Assorted Monetary Musings

1. Chevelle explains  how to do quantitative easing (QE) so that it actually stabilizes aggregate demand.  The previous round of QE--called "credit easing" by Bernanke--was not effective in shoring up nominal spending because it was geared towards stabilizing the financial system. I would complement Chevelle's proposal with an explicit nominal target (e.g. NGDP target, price level target, inflation target, etc.).  That is, have the Fed announced it will do QE until some nominal target is reached and maintained.
2. Speaking of nominal targets, Niklas Blanchard calls for an explicit one along the lines of what they have in New Zealand.  He says we should abandon the myth of central bank independence and have Congresss enforce a nominal target on the Fed. He would prefer a NGDP target--me too--but could settle for anything at this point.  
3. Tyler Cowen provides further discussion on his New York Times piece on the Fed.  Among other things, he (1) reminds conservative inflation hawks that Regan's robust recovery involved inflation above 3%, (2) notes that higher inflation would help the housing market, and (3) says he is open to NGDP targeting. 
4. Scott Sumner says it is time for monetary soul-searching on the left.  He notes that the more liberal mainstream media is currently abuzz about the "massively consequential decisions" now facing the Fed and wonders where such questions were back in late 2008 and early 2009. Back then, the mainstream media was focused on fiscal policy and largely ignored the power of monetary policy, the very issue they are now pushing so hard. 
5. Josh Hendrickson looks at the Eurozone during the credit and housing boom and during the subsequent bust.  He believes the evidence points to monetary policy being too loose during the boom and too tight during the bust.  I think this may have something to do with the Fed's monetary superpower status. 

Monetary Musings

Here are some monetary musings:

(1) In case you still happen to believe the Fed's actions in the early-to-mid 2000s were largely inconsequential and that its monetary policy stance was appropriate then you need to read this article by Barry Ritholtz. He does a great job showing that many of the credit market distortions and misused financial innovations would not not have occurred had interest rates not been pushed so low by the Fed. Ritholtz's article complements the academic literature on the "risk-taking" channel of monetary policy.

(2) Richard Alford, a former NY Fed economist, reviews the Fed's actions leading up to and during this crisis over at Naked Capitalism. He finds much wrong with Fed policies during this time but cautions us to be careful in how we criticize the Fed:

Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it.

Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms. Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG

(3) Josh Hendrickson is thinking about monetary policy using the expanded equation of exchange, an approach I have used before. Here is Josh:

[C]onsider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

I wish textbooks included discussions like this.

Assorted Musings

Here are a few musings:

1. Reflationists receive a smackdown over at Naked Capitalism. There the guest blogger Washington takes to task all those observers who claim we can inflate our way out of the debt crisis. He notes that any inflation benefit will be offset by problems from higher interest rates and creditors fleeing the United States. I am not sure the reflationists of the world ever claimed we should (or even could) eliminate all of our debt problems with inflation, only that we could lighten the real debt burden enough to allow for faster economic recovery. The slightly higher inflation could also be part of a plan that would do more than just lower real debt burdens. It would also increase inflationary expectations--if the higher inflation were perceived to be permanent--and thereby increase current spending.

2. Speaking of smackdowns, George Selgin provides one to the central banks of the world. He argues central banks by default tend to create financial instability:

The present financial crisis shows how central banks can fuel the financial booms that make severe busts possible. Unfortunately, theoretical discussions of central banking badly neglect its role in fostering financial instability, in part because they ignore its history and political origins.

If you find this topic interesting see his talk last year at the CATO monetary policy conference.

3. Further evidence from Marco Del Negro, Gauti Eggertson, Andrea Ferrero, and Nobuhiro Kiyotaki that monetary policy does not run out of ammunition once the policy interest rate hits the lower zero bound:

This paper extends the model in Kiyotaki and Moore (2008) to include nominal wage and price frictions and explicitly incorporates the zero bound on the short-termnominal interest rate. We subject this model to a shock which arguably captures the 2008 US financial crisis. Within this framework we ask: Once interest rate cuts are no longer feasible due to the zero bound, what are the effects of non-standard open market operations in which the government exchanges liquid government liabilities for illiquid private assets? We find that the effect of this non-standard monetary policy can be large at zero nominal interest rates. We show model simulations in which these policy interventions prevented a repeat of the Great Depression in 2008-2009.

The authors conclude, then, that the Fed can have meaningful influence on the economy even when short-term interest rates are at zero percent. If so, then why did not the Fed do more in late 2008 and early 2009 to prevent The Great Nominal Spending Crash?

Assorted Musings

Here are some assorted musings:

(1) Menzie Chinn does a one-year anniversary review of the evidence on Obama's fiscal stimulus and concludes that 1.6 to 2.5 million jobs were created. Given the poor state of the economy this conclusion is based on counterfactual analysis (i.e How much worse would the economy have been had there been no stimulus?). John Taylor says these results are built into the models that make them. Arnold Kling agrees and explains why from a Bayesian perspective:

In Bayesian terms, the weight of the modeler's priors is very, very high, and the weight of the data is close to zero. The data are essentially there just to calibrate the model to the modeler's priors.

This debate will not be settled anytime soon. It also ignores another important question that requires counterfactual analysis: how many jobs would have been saved or created had monetary policy been more aggressive? Recall that monetary policy does not lose its efficacy just because its policy rate hits zero: unconventional monetary policy can still affect aggregate demand in a meaningful way by altering inflation or price level expectations. If you are not convinced just ask Michael Woodford, Paul Krugman, or Scott Sumner for starters.

(2) Tyler Cowen makes the case for the value added tax (VAT) and then asks for good arguments against it. Here is a big one: the VAT does not allow the public to fully internalize the true cost of the federal government. This problem would be particularly pronounced now if the VAT were enacted since about half the the U.S. population pay no federal taxes. If we want voters to make informed decisions about government programs they need to know the true costs and benefits of those programs. While the VAT might widen the tax base and help shrink the deficit in the near term it would also serve to only further externalize the true cost of government spending. In turn, this may eventually lead to a further widening of the budget deficit.

(3) Nick Rowe addresses some of the problems with the Post Keynesian/Chartalist theory of money. As someone who was their poster boy of what is wrong with mainstream macro over the past weekend in the comment section of this post , it is refreshing to see Nick Rowe assess some of their views. Among other things, we learn that they lack a theory of the price level. (We also learned from the earlier post that the money supply and the monetary base are completely and always endogenous. Robert Mugabe, therefore, is a victim not the perpetrator of Zimbabwe's hyperinflation!)

(4) I am a parent of young children and am an economist. Here I learn that I can be a better parent by utilizing my skills as an economist! My wife will love this one.

(5) Who says brain drain in the developing world is a bad thing? Laura Freschi says brain drain has unfairly received a bad rap.

Assorted Musings

Here are some assorted musings:

(1) Despite all the financial problems in Greece, Nouriel Roubini says the real threat to Eurozone is Spain. This emphasis on Spain seems reasonable given that it is the fourth largest economy in the region and is experiencing a severe recession along with an exploding budget deficit. It also appears there now will be a bailout for Greece making it less of a problem for the Eurozone. As I have noted before, these problems all point to the Eurzone not being an optimal currency area and, thus, not well suited to a one-size-fits all monetary policy. Along these lines, it was interesting to read this piece from The Economist:

It is often said that the IMF cannot intervene within the euro zone because it would be too humiliating, politically, for the EU to admit it could not look after one of its core members. That is clearly a view shared by senior officials. However, one source offered a further reason why the IMF is not welcome that I had not heard before. The fund's experts typically offer countries in trouble a mixture of fiscal and monetary advice, he explained: ie, they tell countries to cut public spending and raise taxes, but also to alter interest rates and take steps to stabilise their currency. If the IMF told Greece to cut public sector salaries, say, that would not shock the rest of the EU, he said. But what if the IMF demands that Greece tighten or loosen its monetary policy? Greece shares its monetary policy with the other 15 members of the euro zone: would the ECB be expected to change its monetary policies? And what would Germany have to say about that?

Although the Intrade.com contract on the Eurozone's future says we should not expect too much excitement in 2010, it will be interesting to see whether this currency union will shed some of its periphery over the next few years.

(2) Tyler Cowen seems to be buying into the Great Recalculation story promoted by Arnold Kling. He points to this map as evidence of the Great Recalculation and alludes to the idea in this New York Times discussion over Bernanke's reappointment. Scott Sumner responds by pointing us to this map which indicates the Great Nominal Spending Crash is a better story. I would also encourage Tyler to look at the last figure on this post which shows a broad decline in employment, a development more consistent with Sumner's view.

(3) Speaking of a the Great Nominal Spending Crash, it is worth noting that despite the great GDP numbers released today both domestic demand and aggregate demand are still experiencing low year-over-year growth rates. From these figures on the links above it is apparent that nominal spending is still far too low relative to trend.

(4) Bill Woolsey, in a reply to Scott Sumner post, does a great job summarizing the key questions facing the Fed. He provides answers with which I completely agree--it is almost as if he read my mind. (If only he would also read the part of my mind that sees the Fed's monetary policy in the early-to-mid 2000s as way too accommodating...)

(5) Scott Sumner alerts us to the possibility that the Fed may soon start targeting the demand for bank reserves rather than the federal funds rate. It would do that by adjusting the interest paid on excess reserves as the instrument of monetary policy. If I understand this potential development correctly, the Fed would effectively be targeting a quantity (monetary base) rather than a price (federal funds rate). Is this right or is there more to it?

(6) The always interesting Niall Fegurson discusses Obama's new proposals for regulating banks and finds them lacking. Martin Wolf agrees with him.

Assorted Musings

Here are some more assorted musings:

(1) Caroline Baum asks a probing question: if the Fed is not able to identity an asset bubble and prick it in a timely fashion, how then is it able to know what are appropriate spreads in the credit market as it expands it balance sheet to shore up the financial system? In the former case it claims ignorance and refuses to intervene while in the later case it claims prescience and readily intervenes. Baum notes this asymmetry is typical of Fed policy in recent times.

(2) Has the Fed's independence already been compromised? Nouriel Roubini and Ian Bremmer argue yes and its not because of congressional probbing. Rather, it is because of its bailout of large financial institutions last year. Roubini and Bremmer also explain that if the Fed is not careful it could set the stage once again for the next bubble, a point recently made by Peter Boon and Simon Johnson.

(3) Roberto M. Billi has a new article that examines whether monetary policy was optimal in past deflation scares. He looks at Japan in the period 1990 to 1995 and the United States from 2000 to 2005. Using a Taylor Rule he concludes that monetary policy was too accommodative in the case of the United States. While I concur with his conclusion and have said so before, I also would like to note several things. First, the article assumes that deflation is always economically harmful. Deflation, however, can arise for reasons other than a collapse in aggregate demand. As I have noted before, positive aggregate supply shocks can also generate benign deflationary pressures and this form has far different policy implications than deflation arising from a collapse in nominal spending. Second, when constructing the federal funds rate prescribed the Taylor Rule one needs a measure of the output gap. There are, however, different measures of the output gap and, as result, different implications for the Taylor Rule. A popular version for the United States is the CBO's output gap measure. John Williamson of the San Francisco Fed , however, argues that the CBO measure is flawed since it doesn't allow for short-run fluctuations in the growth rate of potential output. Here is his preferred measure (LW) graphed along with the CBO measure:


The CBO measures show a negative output gap during the housing boom while the LW measure shows a positive output gap. The LW makes more sense for this period. Now plug the LW measure into a Taylor Rule and there is even a stronger case that monetary policy was too loose during the housing boom period. Finally, there are other ways to learn the stance of monetary policy. Here is one measure I like.

Assorted Musings

Some assorted musings:

(1) James Hamilton gives us a reality check on the U.S. debt-to-GDP ratio. He shows that we should not take comfort, as some observers do, in comparing the current value of this ratio to what is was coming out of WWII. Back then there was far more non-mandatory spending that could easily be pared down. A very sobering read. [Update: Paul Krugman replies to Hamilton]

(2) David Andolfatto meanwhile is more optimistic on the growing U.S. debt-to-GDP ratio. He cites Ricardo Caballero's argument that there is a shortage of high-quality financial assets in the world and thus the large increase in U.S. Treasuries is actually an optimal outcome. The world needs our Treasuries and the only way we can provide them is to incur more public debt.

(3) Menzie Chinn has a new paper with Jeffry Frieden where they look at the causes and consequences of the current economic crisis. Among other things, they note that the excess savings from the rest of the world was not forced on the United States. Rather, it responded to the excess U.S. demand pressures created by loose fiscal and monetary policies in the United States. They put more emphasis on fiscal policy than I would, but their key point that U.S. economic policies were the important drivers in the buildup of global economic imbalances is spot on.

(4) Tyler Cowen does a Milton Friedman smackdown of David Henderson. Tyler shows, contrary to David's claims, that Milton Friedman thought the Fed in 1929-1931 period should have (1) bought up a lot more bonds (i.e. increased the money supply) and (2) acted a lender of last resort (i.e. done more to prevent the banking system collapse). In short, Milton Friedman was for both stabilizing the money supply and bailing out the banking system. As Tyler notes, the idea of bailouts is hard for many libertarians to swallow, but the alternative may be a far worse outcome for them.

(5) Speaking of running, Justin Wolfers reminds us there is an opportunity cost to this sport. However, he does the calculations and concludes that training for a marathon is an optimal outcome for him.

Assorted Musings

Here are some more assorted musings

1. Since there are plenty of critical pieces on the economic policies of President Barrack Obama and Fed chairman Ben Bernanke, I think it is only fair to take a look at a few articles that discuss their performances in a balanced manner. To that end here is Jeff Frankel evaluating the Obama administration and here is Thomas Cooley apprasing the Bernanke Fed. Important points that come out from these pieces is that (1) one must consider worse alternative outcomes that could have emerged had certain policies not been adopted and (2) it is only reasonable to expect some policy mistakes be made in policy making when one is the heat of battle with little time to deliberate.


2. As I have noted before, the Fed has some real challenges ahead of it once the recovery starts. Two recent Financial Times (FT) articles highlight some of these looming challenges. First, the FT reported that a large part of Wall Street's recent success is due to its trading with the Fed. These big banks apparently are selling overpriced securities to the Fed. The Fed is allowing this to happen to keep credit markets from freezing up. My question is how will these credit markets ever get weaned from the Fed? Second, the FT in another piece noted that in order for Bernanke to flawlessly execute his exit strategy he will need to have a good measure of the output gap. This metric, however, is not easy to measure, especially so during times of structural change such as the present. Some have argued this was one reason the Fed messed up on the 1970s--it misread the output gap and as a result was too expansionary. Will the Fed get it right this time?
   


3. Dr. Doom (i.e. Nouriel Roubini) becomes Dr. Optimistic in this article where he looks at countries that are doing relatively well given the global recession. A key characteristic he finds among these countries is that they strove to balance their budgets over the business cycle. That is they ran policy such that they saved during the boom years so that they could more easily run accommodative policies during the bust years.


4. Richard Thaler has an interesting Op-Ed in the Financial Times discussing how this crisis should be one of the final nails in the coffin of the efficient market hypothesis (EMH). He makes this point specifically with regards to the EMH implication that asset prices fully reflect all information and provide accurate signals about the fundamentals behind the assets. He noted that now that we have had the Japanese asset bubble in the late 1980s and the U.S. asset bubbles in the late 1990s and mid 2000s, the hard-core advocates of EMH have a lot of explaining to do:

   So where does this leave us? Counting the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be "right", then these bubbles would not occur.

Assorted Musings

Some more assorted musings.

1. This Economist article on the state of marcoeconomics has attracted a lot of attention. Paul Krugman and Brad DeLong both note that the article is not entirely accurate in that some economists, including themselves, did see problems emerging. However, the problems they focused on were the wrong ones:

   The prevailing view was that the truly dangerous financial crisis would be one produced by the unwinding of "global imbalances"--a collapse in the dollar and a panicked flight not toward but away from dollar-denominated cash--that could not be handled by the Federal Reserve because in such a crisis the assets that it would create would be assets that nobody wanted to hold. So I think--surprise, surprise--that Paul Krugman is right here: Pragmatists weren't ignoring the risks of crisis, but they were watching out for the wrong crisis because we had no clue how bad the state of risk management in America's investment banks had become...

   Even this assessment, however, is not completely fair. As I noted previously, the folks at the BIS (1) saw the problems emerging and (2) saw the correct ones. See here for more.


2. The New York Times has a great article explaining the various ways of rationing health care. It shows that no matter how we ration health care--through price, quantity, or quality--tough choices have to be made.


3. NPR did an interesting story on research by Ben Olken and Benjamin Jones that shows temperature negatively affects economic activity:

   They found that for poor countries, an increase in annual average temperature by 1 degree centigrade corresponded to a 1.1 percent drop in per-capita gross domestic product...It's unclear exactly why temperature would have this effect. It might be that crop yields go down, or that disease is more of a problem. Or it might just be what you could call the "sloth" theory — it's hard to work when it's hot out. Who wants to mow the lawn in August?

   I will vouch for sloth theory when it comes to running. When I moved to Michigan I found it relatively easy to acclimate to running in very low temperatures. After moving to Texas, though, I found adjusting to running here to be far more challenging. ( I still marvel at those folks who go for runs in early afternoon here in Texas when temperatures are 100+; my runs are always early in the morning when it is cooler.) I am only one data point, but from my experience I am open to notion that economic geography and climate can influence economic activity. Here is their paper.


4. Finally a U.S. monetary policy official admits the Fed contributed to the housing boom. Bloomberg is reporting that the president of the Atlanta Federal Reserve , Deninis Lockart, said the following:

   “Among the causes of the financial crisis was a long period of low interest rates,” he said. It is clear low rates “had something to do with the housing bubble.”

   Lockhart was not around when this happened, so it is easier for him to make theis statement--there is no blood on his hands. It is worth nothing that back in 2003 that Gary Stern, Minneapolis Fed president and voting member of the FOMC did raise questions about the deflation scare of the time. He was not convinced they were truly a threat to macroeconomic stability. Had his views been more widely shared at the Fed maybe the federal funds rate would not have been held so low for so long. [Update: Here is a Stern speech where he questions the conventional wisdom on deflation in 2003.]
   

Assorted Musings

More assorted musings:

1. The saving glut smackdwon continues. First Menzie Chinn dealt it a back-breaking blow, then I pounded it with some monetary superpower, and now Asian officials are pushing back as well.
2. Apparently the Swedish central bank has been reading Scott Sumner's blog. They are now penalizing banks for holding excess reserves. This move is a part of a package where they are effectively cutting interest rates to minus 0.25 percent.
3. Josh Hendrickson has a great post where he reminds us that yes, "inflation is a monetary phenomenon, but this isn't inflation." I hold a similar view.
4. Nick Rowe baits me in for more discussion on whether the Fed actually pushed its policy rate below the natural interest rate in the early-to-mid 2000s. I am convinced it did, Nick is not so sure. See our exchange in the comment's section.
5. Speaking of the natural interest rate here is a graph from an ECB paper that rigorously shows the actual interest rate (red line) did drop below the natural interest rate (black line). Click on figure to enlarge.
6. Here is a great article on Mark Thoma and how he influences the national debate through his blog the Economist's View. The economic blogosphere really has become a force in shaping economic policy. I had a conversation about this with Tyler Cowen and he pointed to, among other things, how the original plans for the TARP were scrapped because of negative feedback from the blogosphere.
   

Assorted Musings

Here are some assorted musings:

1. First there was the interest-rate conundrum in the mid-2000s that stumped the Fed, now there is the steepening yield curve mystery from last week that has the Fed perplexed. The Treasury yield curve is so frustrating some times for the Fed. Fortunately, Rebecca Wilder has some insights on this latest yield curve development.
2. Is Paul Krugman throwing the baby out with the bathwater in his latest column? He argues the fundamental reason we are in this bind is that the financial sector was deregulated in the 1980s, financial innovation took off, and as a result there has been too much borrowing since then. I think many observers would agree there has been a lot of borrowing, but does Krugman really want to inhibit financial innovation just because it makes its easier for individuals to make bad financial decisions? Most inventions and innovations have the potential for creating problems, but instead of outlawing them we try to manage them.
3. Brad Sester notes total U.S. borrowing from the rest of the world is down, even though U.S. government borrowing is exploding. That is because households and business are borrowing a lot less. As a result, government borrowing is offsetting the fall in private borrowing. Here is his summary graph (click on figure to enlarge):
   
   
As Sester explains, though, once the economy recovers and the private sectors starts borrowing again, government borrowing must come down to keep total U.S. borrowing in line. Observers like John Taylor, Niall Ferguson, John Maudlin, and others, however, are concerned that future government spending will not be reversed once the economy recovers. If so, the real question becomes what is the U.S. Debt-to-GDP number that is too big?

Assorted Musings

Here are some assorted musings piled into one post.

1. Just when the IMF thought it was becoming relevant again, the Asian Development Bank Fund moves closer to establishing an Asian Monetary Fund.
   
2. Ben Bernanke is feeling the heat. Congress is planning televised hearings on whether Bernanke and Paulson pressured Ken Lewis and Bank of America (BoA) to be quiet and complete its acquisition of Merrill Lynch after BoA found out there were more problems with the bank. The WSJ reports that the congressional "review of documents, notes from phone conversations involving Federal Reserve officials and other information suggest 'there's fire there.' "
3. Wow. Ben Bernanke was interested in pushing the federal funds rate to 0% in 2003. One can only imagine how much more pronounced the housing bubble and subsequent financial collapse would have been had the policy rate hit 0%.
4. I listened to Russ Robert interview Ed Leamer on EconTalk (while doing grades!). One interesting point that Leamer makes is that no matter what has hit the the U.S. economy it has always returned to its trend growth rate of just over 3% per annum. While this consistency is a remarkable, what I find even more amazing is that the level of the U.S. economy seems to follow a deterministic trend. One striking example of this can be seen by looking at the log level of the U.S. economy after the Great Depression. The U.S. economy is where it would have been--based on a linear trend--had there been no Great Depression! This can be seen in the figure below (click on it to enlarge):
   

In short, the eyeball test seems to indicate that over the long run the U.S. economy is trend stationary not difference stationary. (Menzie Chinn provides some formal evidence that my eyeball test is correct.) It is almost as if this trend is a constant of nature.